Islamic Bonds Default – Will Dubai World Be Next?

I have been following the developments surrounding the Dubai World’s sudden call for a standstill agreement with its creditors.  But there are many articles written about this topic that I hesitated to add a new one.  But now, thanks to a recent Reuters report, it is interesting to look at the issue  from the perspective of Islamic bonds and the recent defaults involving such instruments.  Also of interest, Nakheel, a Dubai World’s subsidiary, has a payment maturing December 14 on an Islamic bond that it issued previously.  Will it default on this payment?

Real estate developer Nakheel previously sold US$3.5 billion worth of Islamic bond.  This is the largest Islamic bond ever issued. But what is an Islamic bond?  Technically it is called a sukuk. It differs from other conventional bonds in that it does not pay interest.  Rather sukuk investors receive returns generated by the underlying assets pooled under special purpose vehicles.

It is an Islamic bond because its structure conform to Sharia law.  Now people may think that because the structure of these these bonds are Sharia compliant, they are safer and more transparent than their conventional counterparts.  But Yusuf Talal DeLorenzo, chief sharia officer at fund management company Shariah Capital said: “If there are lessons to be learned here, it is that due diligence is all important. Compliance to sharia in its structuring does not ensure the success of a sukuk or of any product or business.”

Another industry player said: “Clarity on the structure is essential. The Islamic finance industry must do all it can to avoid accusations of mis-selling products.”

So how safe are the sukuk instruments?  One expert in sukuk said: “The reality is that Middle Eastern property law is so weak that even with asset-backed, people have little confidence in the success of that claim. All the rating agencies have never rated Middle Eastern sukuk in reference to the assets, they only ever rated them in reference to the credit rating of the sponsoring entity. They were rated as unsecured liability.” 

Which begs the question as to whether investors in sukuk instruments truly understand the risks involved.  Now that Dubai World has asked for a standstill agreement, and Nakheel is staring at a possible default come December 14, investors in Nakheel’s sukuk are suddenly feeling very vulnerable.  This is all the more so with the recent announcement that the Dubai government is not responsible for the debts of these entities, notwithstanding that these are owned by the government.

Even before Dubai World shocked everyone with its standstill demand, the sukuk market was not doing well.  Recent defaults include the US$650 million Golden Belt Sukuk Belt 1 Sukuk issued by Saad of Saudi Arabia, which said it would miss payment on the second bi-annual coupon.  And earlier in May, Kuwait’s Investment Dar also defaulted on a US$100 million sukuk.

Investors and lenders are now more careful.  Amjad Hussain, head of banking and Islamic finance, Middle East at law firm Eversheds said: “Lending in the Gulf has often been based on the perceived value of the family name of the borrower or its backers. The current announcement sees that position being eroded. ”

Think about it.  One would think that if sukuk instruments are Sharia compliant, then surely the issuers would not dare default on them.  Sharia law offenders in the Gulf states can have their limbs amputated, their bodies whipped, or they can even be stoned to death.  Surely no one would dare to fool around with these punishments?  But as stated above, all sukuk issues are rated as unsecured.  So it is back to basic – caveat emptor.